4 Takeaways from SEC Registration Charge Settlements with Airfox and Paragon

First Takeaway: The SEC Means Business and is Polishing their Playbook

First, the recent settlement of SEC Registration charges against Paragon and Airfox on November 16, 2018 is likely the first of many civil penalties levied against cryptocurrency businesses. The ruling also represents an important legal precedent where the SEC applied guidance from the 2017 DAO Report of Investigation (Release №81027 / July 25, 2017). The guidance was used to charge both Airfox and Paragon for violating Section 5(a) and 5(c) of the Securities Act by “offering and selling these securities without having a registration statement filed or in effect with the Commission or qualifying exemption from registration with the Commission.” PRG and Airtokens were represented as “Utility Tokens” to present themselves fundamentally as glorified Kickstarter projects rather than securities.

The DAO Report set a framework to predict how the SEC would interpret securities law when applying them to ICOs despite labels as a security or utility token. Below are a few of the foundational principles of securities law from the DAO Report applied to capital raising via cryptocurrency offerings.

1) Determination of whether an investment contract exists. A key item distinguished was that the investment of “money” does not necessarily need to take the form of fiat currency. Using ETH to make investments was specifically cited (such as exchanges involving smart contracts). Tokens that fit the Howey test are determined to be securities.

2) Reasonable expectation of profits. Despite the focus on funding development projects, the tokens were presented and structured in a manner where a reasonable investor would have been motivated by the “prospect of profits on their investment.”

3) Benefit derived from the managerial efforts of others. The responsibility for shepherding the raised capital and generation of profit was assumed to be tied to the efforts of the management team. This increases in importance when considering management teams using cryptocurrencies to compensate employees and contractors.

4) Voting rights are a critical distinguishing factor. Based on the structure of these companies, there are a number of limiting items for the overall control of token holders. In addition, given that token holders are often widely dispersed and lack the ability to communicate with one another, there is an even greater burden placed on management to prove their efforts are not being relied upon for economic gain.

5) Information rights are important. Whether it is an unplanned hard fork or change in monetization strategy, it is important for token holders to have a reasonable amount of information to make an informed decision. This is likely to increase the burden on management teams to effectively communicate their results and general business plans in a more structured manner.

Second Takeaway: No Fraud Charges Levied

The SEC charged the two companies with a $250,000 fine and a cease-and-desist order until they can be properly registered. Notably, no criminal charges were applied in either case. This demonstrates that the SEC is focused on establishing registration requirements and enforcement mechanisms to create a more predictable ICO market. While these rulings may not establish a clear bright line on a number of other securities items pertaining to cryptocurrency markets, the blue prints for ICO compliance seem to be coming together.

Third Takeaway: Labeling it as a “Utility Token” Means Nothing

None of the defenses based on the label of a “utility token” were strong enough to avoid the categorization of each token as a security. A utility token is issued in order to fund development of a cryptocurrency and future marketplace where the token would be exchanged for a particular good or service. The legal defense of a utility token to avoid the label of a security is tantamount to comparing themselves to Kickstarter projects. However, the SEC determined that the promise and hope of asset inflation creates a fundamental point of distinction.

Fourth Takeaway: Investor Relations is Important

The SEC consistently discussed the promotional efforts on social media, email communications, blockchain communities / chat sites, and white papers in applying securities law. Similar to virtually every other asset class, the overall communication of the opportunity was evaluated in a legal vacuum to determine whether the tokens were securities and if they were exempt from registration.


While there are likely much more settlements in the SEC pipeline, we are starting to see the development of clear standards for ICO markets. This positive trend will culminate in more clear standards for asset monetization strategies using blockchain technology. Future guidance on the following topics are likely over the next few years:

· Equity compensation rules around distribution of cryptocurrency

· Trading rules surrounding secondary markets

· Liquidity requirements (for instance, escrow accounts held in ETH)

· Information rights

· Voting rights

· Governance structure

· Distributed ledger technology security

· Industry-specific applications (i.e., gambling, gaming, cannabis, etc.)

Public Blockchain Companies: Understanding Risk for a New Market

Without the advantage of being part of a reputable VC or Angel group, or actively working on early-stage company investments, public market information offers retail investors with the best knowledge to invest in micro and small cap companies. Due to the asymmetric information and profit potential associated with any new industry, there will always be winners, losers, and fraud. Penny stock trading hacks show that this fraud can be depicted in the form of newsletters, sexy new ‘ICO deals’, fake advisors, and fake thought leaders.

In order to understand this risk, investors typically analyze the trading history of publicly traded stocks and form ratios (e.g., beta, volatility, etc.) to compare. Analysts can then split risk into various categories based on size, geography, industry, and so forth. These ratios are often compared against benchmarks such as the S&P 500 and the Russell 2000 to gauge relative risk of each position. Also, in theory, high risk of a particular stock can be ‘diversified’ through the addition of uncorrelated stocks in the context of a portfolio.

Unfortunately, investors in cryptocurrency assets and companies lack a strong public market to assess these industry and operating risk factors that have been traditionally embedded in the trading prices of public stocks. Since the volatile end of 2017 to the beginning of 2018, investors rushed into the asset class to share in the promises of finding the Treasure of Lima. Comments like “Ethereum and Bitcoin seem to be safe given the attraction of institutional money” or “I’m going to take a shotgun approach and see what sticks” built a guise of both stable and rapid growth, both of which have not played out over the last year.

Rather than focus on the drivers of the market, the intent of this post is to analyze publicly traded companies to better understand risk. We analyzed 29 publicly traded blockchain-focused early-stage companies (Exhibit A) that were primarily pre-revenue in the blockchain industry; the companies trade across various international exchanges such as the TSXV, Nasdaq, and CNSX and on the pink sheets. We then calculated a market capitalization weighted index and observed the Crypto Currencies Index[1] to compare traditional ratios against these two benchmarks. It’s important to remember that these two indices represent different estimates of performance. The average market cap method measures the performance of the 29 selected companies. The CCI 30 index represents performance of cryptocurrency assets. While we would assume the indices to be highly correlated during sharp up and down movements, one area of focus was to see whether there was a decoupling effect between the two asset classes (like the relationship between gold and gold-mining companies) in performance after the recent drawdown of cryptocurrency asset values.

The first chart shows the risk-to-reward ratios (based on calculated weekly performance and volatility since the beginning of 2014) of the 29 companies and the indices. The indices also show greater risk-to-reward ratios, indicating potential benefits of diversification. A majority of the positions illustrate a weekly volatility range of 10 to 30 percent. This implies annual industry volatility of approximately 70% to 200%.

Chart 1 — Plot of Publicly Traded Companies

The second chart illustrates the growth of the market cap weighted index and CCI 30 index compared to the total IPO values (calculated as the market cap on the first trading week) over time. The area chart represents the gross invested capital of each position but ignores and fluctuations in the underlying stock. The indices (represented by the line charts) demonstrate the strong performance of cryptocurrency assets through the beginning of 2018, followed by a sharp fall.

The analysis reveals a few items. First, the trend of asset inflation likely contributed a almost $800 million of new IPO money flowing after the new year. Second, we calculated volatility ratios since the beginning of 2014 (or since inception of the other companies). Calculated off weekly performance, the implied volatility figures were significantly greater than those calculated for general market indices such as the S&P 500 (Exhibit B, at the time of this post the VIX index was trading around 19). In addition, we observed differences in risk associated with business strategy. For example, Hut 8 Mining Corp. represents a relatively recurring revenue type business model. On the other hand, Blockchain Technologies, Inc. is an early stage R&D company focused on applications to IoT. As the industry matures, we expect additional differences and sub-industries to emerge. However, for the most part, it seemed that the two asset classes were fairly correlated over the last 1–2 years.

Chart 2 — New Blockchain Companies

Finally, we wanted to note the obvious shortcomings with the analysis, which include (i) the short trading histories above the different companies, (ii) we ignore invested capital from large strategic companies such as IBM or Oracle, (iii) the private capital markets are substantially larger, and (iv) the initial focus for retail investors has been the currency rather than the underlying equity. Over time, we expect new innovations and industry maturity to allow valuation professionals and investors to increase reliance on traditional valuation tools.


[1] CCI30, Source: https://cci30.com, Represents a barometer of cryptocurrency asset performance by analyzing the top 30 market cap cryptocurrency assets (index methodology is located on their website).